Foreign Direct Investment and Evaluation of Country Risk: An Empirical Investigation

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Abstract:

This paper investigates the extent to which country risk ratings influence the inflow of foreign direct investment (FDI). Using International Monetary Fund (IMF) data from over 100 countries and Euromoney's country risk ratings over a ten-year period, this study finds that country risk ratings have a significant influence on FDI. This effect is stronger for US FDI. We also analyze the relative importance of the individual components of the country risk index.

INTRODUCTION

Despite oft-repeated assertions about the death of the nation state and the birth of the "global village," differences across nations continue to persist in terms of market preferences, economic growth rates, management and governance systems, and choice of organizational goals and strategies. While some countries have attracted an enormous flow of inward investments either in the form of brick and mortar investment by foreign corporations, portfolio investment by institutional investors, or as commercial lending by international banks, several other nations that represent potential growth opportunities have dismally failed in attracting such inflows. The lack of such inflows, in turn, has significantly slowed down the ability of these nations to attain economic growth and higher living standards for its citizens.

All investment decisions, individual or corporate, are primarily driven by two fundamental factors, namely, expectations about returns and assessments of risks (Click, 2005). Sophisticated analytical tools have been developed for the evaluation of both factors at individual and corporate levels. International investments represent additional dimensions of risk that do not apply to investments in a purely domestic context. Although two projects may involve the same rate of return and equivalent commercial risks, a project that is situated in a certain national context may prove to be riskier than an investment in another country. This component of risk is commonly referred to as "country risk." In spite of the general agreement that countries represent different levels of risk due to unique political and economic factors, we are far from developing a commonly agreed upon measure of country risk, a measure that is characterized by theoretical rigor and predictive accuracy. Assessment of country risk remains highly subjective and judgmental despite several attempts to quantify it in terms of risk indices (Gentile 1998; Borio and Packer 2004).

It seems intuitively obvious that perceptions about country risk would have a strong influence on decisions regarding whether to invest in a country, as well as the size of the investment. Considering the complexities involved in evaluating the riskiness of a country given the multitude of idiosyncratic economic, political, and social factors, most investors are not in a position to develop independent assessments of country risk. Instead, such perceptions are greatly influenced by the publication of annual risk ratings by a small number of financial publications and research institutions. Hashmi and Guvenli (1992), for example, find that most firms rely on external providers of political risk assessment. The purpose of this paper is to empirically examine the extent to which foreign direct investment into a country is influenced by indices of country risk.

Assessment of country risk is of vital importance to multinational firms making investments in foreign countries as well as to banks extending loans to clients in these countries for a number of reasons. First, an understanding of the relative levels of risk between countries is essential in deciding which countries to invest in and which countries to avoid. Second, differences in risk levels need to be incorporated into the capital budgeting decisions of MNCs either through higher hurdle rates or lower payback periods. Third, the development of appropriate risk mitigation strategies is not possible without an in-depth understanding of the risk associated with a country. …